Blog – Investors Cold on Turkey

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Heading into elections for the second time in six months, Turkey has endured a historic plunge in its currency and serious declines in its equity market as growth has slowed and political risks have escalated. In tandem with this increased political uncertainty has come an uptick in violence within Turkey as well as on its borders, further threatening a once-vibrant investment climate. We sat down for a discussion about these and other challenges with Caglar Somek, CIO of Caravel Fund
.Given that coalition talks have failed and new elections have been announced for November 1st, what’s the likely outcome and will it resolve or prolong the current political uncertainty?

This is a bit counter consensus, but I believe that returns for the AKP in the upcoming election will be flat or even slightly lower than what they recently polled. Erdogan’s strategy to inflame nationalism in the run-up to the election is pretty transparent to most voters and it’s still the case that only a very few want to grant him the constitutional powers he craves. Overall disaffection with his administration is high and I think recent concerns about the economy will shore up the anti-AKP vote.

… can you tell us a little bit about these growth concerns and their linkage to consumer sentiment and voting patterns in Turkey?

Sure. Unlike many developing markets, the Turkish economy is very flexible with regard to labor. The whole economy is like “at will” employment in the U.S., so hiring and firing is very pro-cyclical and companies can shed costs pretty drastically in response to downturns. However, that makes for a climate where consumers can stop spending even if there is just concern about layoffs and not actual job cuts. This can lead to growth scares like in 2011 where the economy slowed sharply for six months then recovered quite quickly when the pessimism was proved unfounded. Something like that seems to be happening now, sentiment is down, consumption is down and inflation will almost certainly be higher due to the currency depreciation. Stagflation is not good for any ruling party’s poll numbers.

The Central Bank of Turkey has indicated that it’s changing its interest rate corridor and ultimately moving in the direction of a single policy rate. Is there actual movement in this direction and how could this enhance market confidence?

I have been a huge critic of this unorthodox policy because it’s essentially designed to confuse people and disguise tightening, so it doesn’t get noticed by the politicians (read: Erdogan). It’s lost any initial effectiveness it might have had and the country has missed its inflation targets for the last four or five years anyway. At this point a single rate would be positive for markets. One success story and something that has helped mitigate a full-blown crisis is the restrictive regulatory framework imposed on the banking system. It’s cost the largest commercial banks at least 300-400 basis point of ROE but it’s also enhanced the stability of the overall system. We’re talking reserve requirements, extra capital charges for certain types of consumer lending, restrictions on fees for credit cards and the like; banks could have grown considerably more without these restrictions, but the conservatism has also prevented problems. In 2009 Turkish regulatory authorities also banned foreign currency lending to households and banks have squared positions on both currency and interest rate exposures. This will continue to be a good bulwark.

How vulnerable is Turkey now to the inevitable U.S. Fed rate hike?

I think the Central Bank of Turkey’s recent non-move on rates signals that regardless of the country’s fundamentals it plans to follow the U.S. Fed, as opposed to being more proactive. That’s in part why the currency is seen as vulnerable. Turkey is going to have to scramble to continue to attract foreign capital in the wake of the Fed hike as most of its growth is predicated on this borrowing. Lower commodity prices should be contributing to a more benign environment even with the high external debt, but political uncertainty and violence trump all other factors.

FDI is down, probably affected by PKK/ISIS terrorism, and portfolio flows have also come down as “overweights” on Turkey have diminished. Give us a scenario on how Turkey could experience some relief from these investment pressures?

One possible scenario is that the AKP loses again and this forces the party’s hand. Centrist forces within AKP form a coalition with the CHP — in similar fashion to the current unity government in Germany — and Turkey is on the road to restoring the Republic. There would be a renewed emphasis on economic reforms, checks and balances between the judiciary and other branches, a moratorium on the use of corruption charges as a political tool and a general return to more democratic principles. This would give confidence to investors, more privatizations would take place and there would be more incentives for FDI. Theoretically, the AKP could do this tomorrow and markets would immediately rally. On a normalized basis Turkish markets are not so expensive. However, it will take a shock of some kind to move in this direction and the upcoming election results might provide it.

The Lira is at an all time low to the dollar, what’s your view on fx going forward?

Turkey has about 30 billion in Fx reserves, a current account deficit of 5%, government debt-to-GDP at 30% and about 180 billion of foreign-currency-denominated corporate debt. However, against that debt there exists significant offshore foreign holdings and savings, as well as Fx hedges with assets in USD or cash flows in USD. This will provide some relief. So far the currency has gone down about 25% and it’s been a gradual decline allowing for the necessary adjustments to take place, but recently things are happening fast and we might be getting into uncharted territory. If in one day or one week the Lira goes to 350, watch out!

On estimates for 2016 earnings Turkey trades at 8.4x earnings (10.4 for GEMS) which is a 15% discount to its five year history and banks are at historically low valuations. With Q2 aggregate earnings actually posting a positive surprise of 4% with the rest of EM coming in negative is Turkey a great opportunity now?

Because of the political uncertainty no one will add to investments until they know which government and which policies will prevail in the upcoming election. The capital expenditure cycle is currently at a standstill and privatizations will be pushed out to 2016. Essentially, 2015 has been written off. There is fairly high uncertainty on earnings growth going forward and the Turkish market is highly inversely correlated to bond yields, particularly banks. When Turkish 10-years go higher the banks go down. Current bond yields are not reflecting the country’s investment grade rating. Nor are cds spreads, which are widening. There is the potential that the yield curve is predicting a downgrade in the country’s rating due to leverage, political messiness and the currency. And people pay less attention to equity valuation until there is visibility on the economy and politics. In a country like Turkey where you have a current account deficit, you are completely dependent on foreign investors, and it’s not just bonds and external financing but 65% of the stock market ownership comes from foreign portfolio flows. Right now there is a war, the economy is getting worse, the currency is tanking and interest rates will be forced to go up. Not the kind of environment equity investors like.

What types of investments could thrive even in this environment?

Avoid companies with dollar debt or that have no cash flows in USD. Refiners have been a good play and until recently Turkish airlines, but tourism is now impacted by the rise in violence we discussed. However, it’s important to note that Turkey is still an all-important transit point so these volumes might not drop off as much as feared. Domestic distributors of electricity have high leverage and are interesting short plays. Names that benefit from the secular health care story are good but carry premium valuations. I like special situations that are neutral to currency, like casinos in Cyprus that have dollar earnings. The white goods exporters have been resilient and Iran is opening up, which will affect a lot of Turkish companies positively, particularly autos and companies that benefit from cheap oil and gas and some stability in the supply stock diversifying to Iran, like chemical companies.

Executive Summary

Alexander Schay

Partner & Managing Director Ultima Thule Research

Alexander Schay is a Managing Director at Ultima Thule, an equity research company focused on developing markets and an equity partner at WK Associates, a boutique energy consulting firm with a specialization in emerging market oil and gas.

Alex holds both an MS in Risk Management and an MBA from the Stern School of Business at New York University.